THE SUPERINVESTORS
OF GRAHAM-AND-DODDSVILLE

by Warren E. Buffett

“Superinvestor” Warren E. Buffett, who got an A+ from Ben Graham at Columbia in 1951, never stopped making the grade. He made his fortune using the principles of Graham & Dodd’s Security Analysis. Here, in celebration of the fiftieth anniversary of that classic text, he tracks the records of investors who stick to the “value approach” and have gotten rich going by the book.

Is the Graham and Dodd "look for values with a significant margin of safety relative to prices" approach to security analysis out of date? Many of the professors who write textbooks today say yes. They argue that the stock market is efficient; that is, that stock prices reflect everything that is known about a company's prospects and about the state of the economy. There are no undervalued stocks, these theorists argue, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky. "If prices fully reflect available information, this sort of investment adeptness is ruled out," writes one of today's textbook authors.

Well, maybe. But I want to present to you a group of investors who have, year in and year out, beaten the Standard & Poor's 500 stock index. The hypothesis that they do this by pure chance is at least worth examining. Crucial to this examination is the fact that these winners were all well known to me and pre-identified as superior investors, the most recent identification occurring over fifteen years ago. Absent this condition - that is, if I had just recently searched among thousands of records to select a few names for you this morning -- I would advise you to stop reading right here. I should add that all of these records have been audited. And I should further add that I have known many of those who have invested with these managers, and the checks received by those participants over the years have matched the stated records.

Before we begin this examination, I would like you to imagine a national coin-flipping contest. Let's assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000. 

Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvellous insights they bring to the field of flipping.

Assuming that the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million. $225 million would have been lost, $225 million would have been won.

By then, this group will really lose their heads. They will probably write books on "How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning." Worse yet, they'll probably start jetting around the country attending seminars on efficient coin-flipping and tackling sceptical professors with, " If it can't be done, why are there 215 of us?"

By then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same - 215 egotistical orangutans with 20 straight winning flips.

I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if

a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if

b) 215 winners were left after 20 days; and if

c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something.

So you would probably go out and ask the zoo keeper about what he's feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.

Scientific inquiry naturally follows such a pattern. If you were trying to analyze possible causes of a rare type of cancer -- with, say, 1,500 cases a year in the United States -- and you found that 400 of them occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables. You know it's not random chance that 400 come from a small area. You would not necessarily know the causal factors, but you would know where to search.

I submit to you that there are ways of defining an origin other than geography. In addition to geographical origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.

Conditions could exist that would make even that concentration unimportant. Perhaps 100 people were simply imitating the coin-flipping call of some terribly persuasive personality. When he called heads, 100 followers automatically called that coin the same way. If the leader was part of the 215 left at the end, the fact that 100 came from the same intellectual origin would mean nothing. You would simply be identifying one case as a hundred cases. Similarly, let's assume that you lived in a strongly patriarchal society and every family in the United States conveniently consisted of ten members. Further assume that the patriarchal culture was so strong that, when the 225 million people went out the first day, every member of the family identified with the father's call. Now, at the end of the 20-day period, you would have 215 winners, and you would find that they came from only 21.5 families. Some naive types might say that this indicates an enormous hereditary factor as an explanation of successful coin-flipping. But, of course, it would have no significance at all because it would simply mean that you didn't have 215 individual winners, but rather 21.5 randomly distributed families who were winners.

In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham. But the children who left the house of this intellectual patriarch have called their "flips" in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by the fact that they are all calling flips identically because a leader is signalling the calls for them to make. The patriarch has merely set forth the intellectual theory for making coin-calling decisions, but each student has decided on his own manner of applying the theory.

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist's concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc. Incidentally, when businessmen buy businesses, which is just what our Graham & Dodd investors are doing through the purchase of marketable stocks -- I doubt that many are cranking into their purchase decision the day of the week or the month in which the transaction is going to occur. If it doesn't make any difference whether all of a business is being bought on a Monday or a Friday, I am baffled why academicians invest extensive time and effort to see whether it makes a difference when buying small pieces of those same businesses. Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value. 

I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before? Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn't necessarily because such studies have any utility; it's simply that the data are there and academicians have [worked] hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.

I think the group that we have identified by a common intellectual home is worthy of study. Incidentally, despite all the academic studies of the influence of such variables as price, volume, seasonality, capitalization size, etc., upon stock performance, no interest has been evidenced in studying the methods of this unusual concentration of value-oriented winners.

I begin this study of results by going back to a group of four of us who worked at Graham-Newman Corporation from 1954 through 1956. There were only four -- I have not selected these names from among thousands. I offered to go to work at Graham-Newman for nothing after I took Ben Graham's class, but he turned me down as overvalued. He took this value stuff very seriously! After much pestering he finally hired me. There were three partners and four of us as the "peasant" level. All four left between 1955 and 1957 when the firm was wound up, and it's possible to trace the record of three.

The first example (see Table 1) is that of Walter Schloss. Walter never went to college, but took a course from Ben Graham at night at the New York Institute of Finance. Walter left Graham-Newman in 1955 and achieved the record shown here over 28 years. Here is what "Adam Smith" -- after I told him about Walter -- wrote about him in Supermoney (1972):

He has no connections or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that's about it.

In introducing me to (Schloss) Warren had also, to my mind, described himself. "He never forgets that he is handling other people's money, and this reinforces his normal strong aversion to loss." He has total integrity and a realistic picture of himself. Money is real to him and stocks are real -- and from this flows an attraction to the "margin of safety" principle.

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that's all he does. He doesn't worry about whether it's January, he doesn't worry about whether it's Monday, he doesn't worry about whether it's an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do -- and is far less interested in the underlying nature of the business; I don't seem to have very much influence on Walter. That's one of his strengths; no one has much influence on him.

The second case is Tom Knapp, who also worked at Graham-Newman with me. Tom was a chemistry major at Princeton before the war; when he came back from the war, he was a beach bum. And then one day he read that Dave Dodd was giving a night course in investments at Columbia. Tom took it on a non-credit basis, and he got so interested in the subject from taking that course that he came up and enrolled at Columbia Business School, where he got the MBA degree. He took Dodd's course again, and took Ben Graham's course. Incidentally, 35 years later I called Tom to ascertain some of the facts involved here and I found him on the beach again. The only difference is that now he owns the beach!

In 1968, Tom Knapp and Ed Anderson, also a Graham disciple, along with one or two other fellows of similar persuasion, formed Tweedy, Browne Partners, and their investment results appear in Table 2. Tweedy, Browne built that record with very wide diversification. They occasionally bought control of businesses, but the record of the passive investments is equal to the record of the control investments.

Table 3 describes the third member of the group who formed Buffett Partnership in 1957. The best thing he did was to quit in 1969. Since then, in a sense, Berkshire Hathaway has been a continuation of the partnership in some respects. There is no single index I can give you that I would feel would be a fair test of investment management at Berkshire. But I think that any way you figure it, it has been satisfactory.

Table 4 shows the record of the Sequoia Fund, which is managed by a man whom I met in 1951 in Ben Graham's class, Bill Ruane. After getting out of Harvard Business School, he went to Wall Street. Then he realized that he needed to get a real business education so he came up to take Ben's course at Columbia, where we met in early 1951. Bill's record from 1951 to 1970, working with relatively small sums, was far better than average. When I wound up Buffett Partnership I asked Bill if he would set up a fund to handle all our partners, so he set up the Sequoia Fund. He set it up at a terrible time, just when I was quitting. He went right into the two-tier market and all the difficulties that made for comparative performance for value-oriented investors. I am happy to say that my partners, to an amazing degree, not only stayed with him but added money, with the happy result shown here.

There's no hindsight involved here. Bill was the only person I recommended to my partners, and I said at the time that if he achieved a four-point-per-annum advantage over the Standard & Poor's, that would be solid performance. Bill has achieved well over that, working with progressively larger sums of money. That makes things much more difficult. Size is the anchor of performance. There is no question about it. It doesn't mean you can't do better than average when you get larger, but the margin shrinks. And if you ever get so you're managing two trillion dollars, and that happens to be the amount of the total equity valuation in the economy, don't think that you'll do better than average!

I should add that in the records we've looked at so far, throughout this whole period there was practically no duplication in these portfolios. These are men who select securities based on discrepancies between price and value, but they make their selections very differently. Walter's largest holdings have been such stalwarts as Hudson Pulp & Paper and Jeddo Highland Coal and New York Trap Rock Company and all those other names that come instantly to mind to even a casual reader of the business pages. Tweedy Browne's selections have sunk even well below that level in terms of name recognition. On the other hand, Bill has worked with big companies. The overlap among these portfolios has been very, very low. These records do not reflect one guy calling the flip and fifty people yelling out the same thing after him.

 Table 5 is the record of a friend of mine who is a Harvard Law graduate, who set up a major law firm. I ran into him in about 1960 and told him that law was fine as a hobby but he could do better. He set up a partnership quite the opposite of Walter's. His portfolio was concentrated in very few securities and therefore his record was much more volatile but it was based on the same discount-from-value approach. He was willing to accept greater peaks and valleys of performance, and he happens to be a fellow whose whole psyche goes toward concentration, with the results shown. Incidentally, this record belongs to Charlie Munger, my partner for a long time in the operation of Berkshire Hathaway. When he ran his partnership, however, his portfolio holdings were almost completely different from mine and the other fellows mentioned earlier.

Table 6 is the record of a fellow who was a pal of Charlie Munger's -- another non-business school type -- who was a math major at USC. He went to work for IBM after graduation and was an IBM salesman for a while. After I got to Charlie, Charlie got to him. This happens to be the record of Rick Guerin. Rick, from 1965 to 1983, against a compounded gain of 316 percent for the S&P, came off with 22,200 percent, which probably because he lacks a business school education, he regards as statistically significant.

One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn't take at all. It's like an inoculation. If it doesn't grab a person right away, I find that you can talk to him for years and show him records, and it doesn't make any difference. They just don't seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he's applying it five minutes later. I've never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn't seem to be a matter of IQ or academic training. It's instant recognition, or it is nothing.

Table 7 is the record of Stan Perimeter. Stan was a liberal arts major at the University of Michigan who was a partner in the advertising agency of Bozell & Jacobs. We happened to be in the same building in Omaha. In 1965 he figured out I had a better business than he did, so he left advertising. Again, it took five minutes for Stan to embrace the value approach.

Perimeter does not own what Walter Schloss owns. He does not own what Bill Ruane owns. These are records made independently. But every time Perimeter buys a stock it's because he's getting more for his money than he's paying. That's the only thing he's thinking about. He's not looking at quarterly earnings projections, he's not looking at next year's earnings, he's not thinking about what day of the week it is, he doesn't care what investment research from any place says, he's not interested in price momentum, volume, or anything. He's simply asking: what is the business worth?

Table 8 and Table 9 are the records of two pension funds I've been involved in. They are not selected from dozens of pension funds with which I have had involvement; they are the only two I have influenced. In both cases I have steered them toward value-oriented managers. Very, very few pension funds are managed from a value standpoint. Table 8 is the Washington Post Company's Pension Fund. It was with a large bank some years ago, and I suggested that they would do well to select managers who had a value orientation.

As you can see, overall they have been in the top percentile ever since they made the change. The Post told the managers to keep at least 25 percent of these funds in bonds, which would not have been necessarily the choice of these managers. So I've included the bond performance simply to illustrate that this group has no particular expertise about bonds. They wouldn't have said they did. Even with this drag of 25 percent of their fund in an area that was not their game, they were in the top percentile of fund management. The Washington Post experience does not cover a terribly long period but it does represent many investment decisions by three managers who were not identified retroactively.

Table 9 is the record of the FMC Corporation fund. I don't manage a dime of it myself but I did, in 1974, influence their decision to select value-oriented managers. Prior to that time they had selected managers much the same way as most larger companies. They now rank number one in the Becker survey of pension funds for their size over the period of time subsequent to this "conversion" to the value approach. Last year they had eight equity managers of any duration beyond a year. Seven of them had a cumulative record better than the S&P. The net difference now between a median performance and the actual performance of the FMC fund over this period is $243 million. FMC attributes this to the mindset given to them about the selection of managers. Those managers are not the managers I would necessarily select but they have the common denominators of selecting securities based on value.

So these are nine records of "coin-flippers" from Graham-and-Doddsville. I haven't selected them with hindsight from among thousands. It's not like I am reciting to you the names of a bunch of lottery winners -- people I had never heard of before they won the lottery. I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It's very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.

I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.

I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, "I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million." I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles of $8 million each. Since you don't have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that's not a difficult job.

You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.

In conclusion, some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It's likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.

Warren E. Buffett, is chairman and chief executive officer of Berkshire Hathaway, Inc. an Omaha-based insurer with major holdings in several other industries, including General Foods, Xerox and Washington Post Company

After getting an A+ in Benjamin Graham’s class and graduating from Columbia Business School in 1951, Buffett went to work on Wall Street at Graham Newman & Company. In 1957, founded his own partnership which he ran for ten years. This article is based on a speech he gave at Columbia Business School, May 17, 1984 at a seminar marking the 50th anniversary of the publication of Benjamin Graham and David Dodd’s Security Analysis.

DARE TO BE GREAT

Memo to:         Oaktree Clients

From:               Howard Marks

Re:                   Dare to Be Great II

In September 2006, I wrote a memo entitled Dare to Be Great, with suggestions on how institutional investors might approach the goal of achieving superior investment results.  I’ve had some additional thoughts on the matter since then, meaning it’s time to return to it.  Since fewer people were reading my memos in those days, I’m going to start off repeating a bit of its content and go on from there.

About a year ago, a sovereign wealth fund that’s an Oaktree client asked me to speak to their leadership group on the subject of what makes for a superior investing organization.  I welcomed the opportunity.  The first thing you have to do, I told them, is formulate an explicit investing creed.  What do you believe in?  What principles will underpin your process?  The investing team and the people who review their performance have to be in agreement on questions like these:

• Is the efficient market hypothesis relevant?  Do efficient markets exist?  Is it possible to “beat the market”?  Which markets?  To what extent?
• Will you emphasize risk control or return maximization as the primary route to success (or do you think it’s possible to achieve both simultaneously)? 
•  Will you put your faith in macro forecasts and adjust your portfolio based on what they say?
• How do you think about risk?  Is it volatility or the probability of permanent loss?  Can it be predicted and quantified a priori?  What’s the best way to manage it?
•  How reliably do you believe a disciplined process will produce the desired results?  That is, how do you view the question of determinism versus randomness?
• Most importantly for the purposes of this memo, how will you define success, and what risks will you take to achieve it?  In short, in trying to be right, are you willing to bear the inescapable risk of being wrong? 

Passive investors, benchmark huggers and herd followers have a high probability of achieving average performance and little risk of falling far short.  But in exchange for safety from being much below average, they surrender their chance of being much above average. All investors have to decide whether that’s okay.  And, if not, what they’ll do about it.

The more I think about it, the more angles I see in the title Dare to Be Great.  Who wouldn’t dare to be great?  No one.  Everyone would love to have outstanding performance.  The real question is whether you dare to do the things that are necessary in order to be great.  Are you willing to be different, and are you willing to be wrong?  In order to have a chance at great results, you have to be open to being both.

DARE TO BE DIFFERENT

Here’s a line from Dare to Be Great:  “This just in: you can’t take the same actions as everyone else and expect to outperform.”  Simple, but still appropriate. 

For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile.  What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money?  No one has ever answered it right. 

The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors.  If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different.  And being different is absolutely essential if you want a chance at being superior.  In order to get into the top of the performance distribution, you have to escape from the crowd.  There are many ways to try.  They include being active in unusual market niches; buying things others haven’t found, don’t like or consider too risky to touch; avoiding market darlings that the crowd thinks can’t lose; engaging in contrarian cycle timing; and concentrating heavily in a small number of things you think will deliver exceptional performance.

Dare to Be Great included the two-by-two matrix and paragraph below.  Several people told me the matrix was helpful. 

Of course it’s not that easy and clear-cut, but I think that’s the general situation.  If your behaviour and that of your managers is conventional, you’re likely to get conventional results – either good or bad.  Only if your behaviour is unconventional is your performance likely to be unconventional . . . and only if your judgments are superior is your performance likely to be above average.

For those who define investment success as being “average or better,” three of the four cells of the matrix represent satisfactory outcomes.  But if you define success strictly as being superior, only one of the four will do, and it requires unconventional behaviour.  More from the 2006 memo:

The bottom line on striving for superior performance has a lot to do with daring to be great.  Especially in terms of asset allocation, “can’t lose” usually goes hand-in-hand with “can’t win.”  One of the investor’s or the committee’s first and most fundamental decisions has to be on the question of how far out the portfolio will venture.  How much emphasis should be put on diversifying, avoiding risk and ensuring against below-pack performance, and how much on sacrificing these things in the hope of doing better?

In the memo I mentioned my favorite fortune cookie: “the cautious seldom err or write great poetry.”  Like the title Dare to Be Great, I find the fortune cookie thought-provoking.  It can be taken as urging caution, since it reduces the likelihood of error.  Or it can be taken as saying you should avoid caution, since it can keep you from doing great things.  Or both.  No right or wrong answer, but a choice . . . and hopefully a conscious one. 

It Isn’t Easy Being Different

In the 2006 memo, I borrowed two quotes from Pioneering Portfolio Management by David Swensen of Yale.  They’re my absolute favorites on the subject of institutional behavior.  Here’s the first:

Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

“Uncomfortably idiosyncratic” is a terrific phrase.  There’s a great deal of wisdom in those two words.  What’s idiosyncratic is rarely comfortable . . . and in order for something to be comfortable, it usually has to be conventional.  The road to above average performance runs through unconventional, uncomfortable investing.  Here’s how I put it in 2006:

Non-consensus ideas have to be lonely.  By definition, non-consensus ideas that are popular, widely held or intuitively obvious are an oxymoron.  Thus such ideas are uncomfortable; non-conformists don’t enjoy the warmth that comes with being at the center of the herd.  Further, unconventional ideas often appear imprudent.  The popular definition of “prudent” – especially in the investment world – is often twisted into “what everyone does.” 

Most great investments begin in discomfort.  The things most people feel good about – investments where the underlying premise is widely accepted, the recent performance has been positive and the outlook is rosy – are unlikely to be available at bargain prices.  Rather, bargains are usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late.    

But it isn’t easy to do things that entail discomfort.  It’s no coincidence that distressed debt has been the source of many successful investments for Oaktree; there’s no such thing as a distressed company that everyone reveres.  In 1988, when Bruce Karsh and I organized our first fund to invest in the debt of companies seemingly at death’s door, the very idea made it hard to raise money, and investing required conviction – on the clients’ part and our own – that our analysis and approach would mitigate the risk.  The same discomfort, however, is what caused distressed debt to be priced cheaper than it should have been, and thus the returns to be consistently high.

DARE TO BE WRONG

“You have to give yourself a chance to fail.”  That’s what Kenny “The Jet” Smith said on TV the other night during the NCAA college basketball tournament, talking about a star player who started out cold and as a result attempted too few shots in a game his team lost.  It’s a great way to make the point.  Failure isn’t anyone’s goal, of course, but rather an inescapable potential consequence of trying to do really well. 

Any attempt to compile superior investment results has to entail acceptance of the possibility of being wrong.  The matrix on page two shows that since conventional behavior is sure to produce average performance, people who want to be above average can’t expect to get there by engaging in conventional behavior.  Their behavior has to be different.  And in the course of trying to be different and better, they have to bear the risk of being different and worse.  That truth is simply unarguable.  There is no way to strive for the former that doesn’t require bearing the risk of the latter.

The truth is, almost everything about superior investing is a two-edged sword:

• If you invest, you will lose money if the market declines.
•  If you don’t invest, you will miss out on gains if the market rises.

• Market timing will add value if it can be done right.
•  Buy-and-hold will produce better results if timing can’t be done right

• Aggressiveness will help when the market rises but hurt when it falls.
•  Defensiveness will help when the market falls but hurt when it rises.

• If you concentrate your portfolio, your mistakes will kill you.
• If you diversify, the payoff from your successes will be diminished.

• If you employ leverage, your successes will be magnified.
• If you employ leverage, your mistakes will be magnified.

Each of these pairings indicates symmetry.  None of the tactics listed will add value if it’s right but not subtract if it’s wrong.  Thus none of these tactics, in and of itself, can hold the secret to dependably above average investment performance.

There’s only one thing in the investment world that isn’t two-edged, and that’s “alpha”: superior insight or skill.  Skill can help in both up markets and down markets.  And by making it more likely that your decisions are right, superior skill can increase the expected benefit from concentration and leverage.  But that kind of superior skill by definition is rare and elusive.

The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls.  But that doesn’t mean the avoidance of all losses is a reasonable objective.  Take another look at the goal of asymmetry set out above: it talks about achieving a preponderance of gain over loss, not avoiding all chance of loss. 

To succeed at any activity involving the pursuit of gain, we have to be able to withstand the possibility of loss.  A goal of avoiding all losses can render success unachievable almost as readily as can the occurrence of too many losses.  Here are three examples of “loss prevention strategies” that can lead to failure:

• I play tennis.  But if when I start a match I promise myself that I won’t commit a single double fault, I’ll never be able to put enough “mustard” on my second serve to keep it from being easy for my opponent to put away.

• Likewise, coming out ahead at poker requires that I win a lot on my winning hands and lose less on my losers.  But insisting that I’ll never play anything but “the nuts” – the hand that can’t possibly be beat – will keep me from playing lots of hands that have a good chance to win but aren’t sure things.

• For a real-life example, Oaktree has always emphasized default avoidance as the route to outperformance in high yield bonds. Thus our default rate has consistently averaged just 1/3 of the universe default rate, and our risk-adjusted return has beaten the indices. But if we had insisted on – and designed compensation to demand – zero defaults, I’m sure we would have been too risk averse and our performance wouldn’t have been as good.  As my partner Sheldon Stone puts it, “If you don’t have any defaults, you’re taking too little risk.”

When I first went to work at Citibank in 1968, they had a slogan that “scared money never wins.”  It’s important to play judiciously, to have more successes than failures, and to make more on your successes than you lose on your failures.  But it’s crippling to have to avoid all failures, and insisting on doing so can’t be a winning strategy.  It may guarantee you against losses, but it’s likely to guarantee you against gains as well.  Here’s some helpful wisdom on the subject from Wayne Gretzky, considered by many to be the greatest hockey player who ever lived: “You miss 100% of the shots you don’t take.”

There is no formulaic approach to investing that can be depended on to produce superior risk-adjusted returns.  There can’t be.  In a relatively fair or “efficient” market – and the concerted efforts of investors to find underpriced assets tend to make most markets quite fair – asymmetry is reduced, and a formula that everyone can access can’t possibly work. 

As John Kenneth Galbraith said, “There is nothing reliable to be learned about making money.  If there were, study would be intense and everyone with a positive IQ would be rich.”  If merely applying a formula that’s available to everyone could be counted on to provide easy profits, where would those profits come from?  Who would be the losers in those transactions?  Why wouldn’t those people study and apply the formula also?

Or as Charlie Munger told me, “It’s not supposed to be easy.  Anyone who finds it easy is stupid.”  In other words, anyone who thinks it can be easy to succeed at investing is being simplistic and superficial, and ignoring investing’s complex and competitive nature. 

Why should superior profits be available to the novice, the untutored or the lazy?  Why should people be able to make above average returns without hard work and above average skill, and without knowing something most others don’t know?  And yet many individuals invest based on the belief that they can.  (If they didn’t believe that, wouldn’t they index or, at a minimum, turn over the task to others?) 

No, the solution can’t lie in rigid tactics, publicly available formulas or loss-eliminating rules . . . or in complete risk avoidance.  Superior investment results can only stem from a better-than-average ability to figure out when risk-taking will lead to gain and when it will end in loss.  There is no alternative.

DARE TO LOOK WRONG

This is really the bottom-line: not whether you dare to be different or to be wrong, but whether you dare to look wrong.

Most people understand and accept that in their effort to make correct investment decisions, they have to accept the risk of making mistakes.  Few people expect to find a lot of sure things or achieve a perfect batting average.

While they accept the intellectual proposition that attempting to be a superior investor has to entail the risk of loss, many institutional investors – and especially those operating in a political or public arena – can find it unacceptable to look significantly wrong.  Compensation cuts and even job loss can befall the institutional employee who’s associated with too many mistakes. 

As Pensions & Investments said on March 17 regarding a big West Coast bond manager currently in the news, whom I’ll leave nameless:

. . . asset owners are concerned that doing business with the firm could bring unwanted attention, possibly creating headline risk and/or job risk for them. . . .

One [executive] at a large public pension fund said his fund recently allocated $100 million for emerging markets, its first allocation to the firm.  He said he wouldn’t do that today, given the current situation, because it could lead to second-guessing by his board and the local press. 

“If it doesn’t work out, it looks like you don’t know what you are doing,” he said.

 As an aside, let me say I find it perfectly logical that people should feel this way.  Most “agents” – those who invest the money of others – will benefit little from bold decisions that work but will suffer greatly from bold decisions that fail.  The possibility of receiving an “attaboy” for a few winners can’t balance out the risk of being fired after a string of losers.  Only someone who’s irrational would conclude that the incentives favor boldness under these circumstances.  Similarly, members of a non-profit organization’s investment committee can reasonably conclude that bearing the risk of embarrassment in front of their peers that accompanies bold but unsuccessful decisions is unwarranted given their volunteer positions.

I’m convinced that for many institutional investment organizations the operative rule – intentional or unconscious – is this: “We would never buy so much of something that if it doesn’t work, we’ll look bad.”  For many agents and their organizations, the realities of life mandate such a rule.  But people who follow this rule must understand that by definition it will keep them from buying enough of something that works for it to make much of a difference for the better.

In 1936, the economist John Maynard Keynes wrote in The General Theory of Employment, Interest and Money, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally” [italics added].  For people who measure success in terms of dollars and cents, risk taking can pay off when gains on winners are netted out against losses on losers.  But if reputation or job retention is what counts, losers may be all that matter, since winners may be incapable of outweighing them.  In that case, success may hinge entirely on the avoidance of unconventional behavior that’s unsuccessful. 

Often the best way to choose between alternative courses of action is by figuring out which has the highest “expected value”: the total value arrived at by multiplying each possible outcome by its probability of occurring and summing the results.  As I learned from my first textbook at Wharton fifty years ago (Decisions Under Uncertainty by C. Jackson Grayson, Jr.), if one act has a higher expected value than another and “. . . if the decision maker is willing to regard the consequences of each act-event in purely monetary terms, then this would be the logical act to choose.  Keeping in mind, however, that only one event and its consequence will occur (not the weighted average consequence),” agents may not be able to choose on the basis of expected value or the weighted average of all possible consequences.  If a given action has potential bad consequences that are absolutely unacceptable, the expected value of all of its consequences – both good and bad – can be irrelevant. 

Given the typical agent’s asymmetrical payoff table, the rule for institutional investors underlined above is far from nonsensical.  But if it is adopted, this should be done with awareness of the likely result: over-diversification.  This goes all the way back to the beginning of this memo, and each organization’s need to establish its creed.  In this case, the following questions must be answered: 

•  In trying to achieve superior investment results, to what extent will we concentrate on investments, strategies and managers we think are outstanding?  Will we do this despite the potential of our decisions to be wrong and bring embarrassment? 

• Or will fear of error, embarrassment, criticism and unpleasant headlines make us diversify highly, emulate the benchmark portfolio and trade boldness for safety?  Will we opt for low-cost, low-aspiration passive strategies?

In the course of the presentation described at the beginning of this memo, I pointed out to the sovereign wealth fund’s managers that they had allocated close to a billion dollars to Oaktree’s management over the preceding 15 years.  Although that sounds like a lot of money, it actually amounts to only a few tenths of a percent of what the world guesses their assets to be.  And given our funds’ cycle of investing and divesting, that means they didn’t have even a few tenths of a percent of their capital with us at any one time.  Thus, despite our good performance, I think it’s safe to say Oaktree couldn’t have had a meaningful impact on the fund’s overall results.  Certainly one would associate this behavior with an extreme lack of risk tolerance and a high aversion to headline risk.  I urged them to consider whether this reflects their real preference.

Lou Brock of the St. Louis Cardinals was one of baseball’s best base stealers between 1966 and 1974.  He’s the source of a great quote: “Show me a guy who’s afraid to look bad, and I’ll show you a guy you can beat every time.”  What he meant (with apologies to readers who don’t understand baseball) is that in order to prevent a great runner from stealing a base, a pitcher may have to throw over to the bag ten times in a row to hold him close, rather than pitch to the batter.  But after a few such throws, a pitcher can look like a scaredy-cat and be booed.  Pitchers who were afraid of those things were easy pickings for Lou Brock.  Fear of looking bad ensured their failure.

LOOKING RIGHT CAN BE HARDER THAN BEING RIGHT

Fear of looking bad can be particularly debilitating to an investor, client or manager.  This is because of how hard it is to consistently make correct investment decisions.  Some of this comes from my last memo, on the role of luck.

•  First, it’s hard to consistently make decisions that correctly factor in all of the relevant facts and considerations (i.e., it’s hard to be right).
•  Second, it’s far from certain that even “right” decisions will be successful, since every decision requires assumptions about what the future will look like, and even reasonable assumptions can be thwarted by the world’s randomness.  Thus many correct decisions will result in failure (i.e., it’s hard to look right). 
• Third, even well-founded decisions that eventually turn out to be right are unlikely to do so promptly.  This is because not only are future events uncertain, their timing is particularly variable (i.e., it’s impossible to look right on time).

This brings me to one of my three favorite adages: “Being too far ahead of your time is indistinguishable from being wrong.”  The fact that something’s cheap doesn’t mean it’s going to appreciate tomorrow; it can languish in the bargain basement.  And the fact that something’s overpriced certainly doesn’t mean it’ll fall right away; bull markets can go on for years.  As Lord Keynes observed, “the market can remain irrational longer than you can remain solvent.”

Alan Greenspan warned of “irrational exuberance” in December 1996, but the stock market continued upward for more than three years.  A brilliant manager I know who turned bearish around the same time had to wait until 2000 to be proved correct . . . during which time his investors withdrew much of their capital.  He wasn’t “wrong,” just early.  But that didn’t make his experience any less painful. 

Likewise, John Paulson made the most profitable trade in history by shorting mortgage securities in 2006.  Many others entered into the same transactions, but too early.  When the bets failed to work at first, the appearance of being on the wrong track ate into the investors’ ability to stick with their decision, and they were forced to close out positions that would have been extremely profitable.

In order to be a superior investor, you need the strength to diverge from the herd, stand by your convictions, and maintain positions until events prove them right.  Investors operating under harsh scrutiny and unstable working conditions can have a harder time doing this than others.

That brings me to the second quote I promised from Yale’s David Swensen:

. . . active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel.   

 Charlie Munger was right about it not being easy.  I’m convinced that everything that’s important in investing is counterintuitive, and everything that’s obvious is wrong.  Staying with counterintuitive, idiosyncratic positions can be extremely difficult for anyone, especially if they look wrong at first.  So-called “institutional considerations” can make it doubly hard. 

Investors who aspire to superior performance have to live with this reality.  Unconventional behavior is the only road to superior investment results, but it isn’t for everyone.  In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes.  Thus each person has to assess whether he’s temperamentally equipped to do these things and whether his circumstances – in terms of employers, clients and the impact of other people’s opinions – will allow it . . . when the chips are down and the early going makes him look wrong, as it invariably will.  Not everyone can answer these questions in the affirmative.  It’s those who believe they can that should take a chance on being great.

The Lessons of Oil

Memo to:     Oaktree Clients

From:            Howard Marks

 Re:                 The Lessons of Oil

I want to provide a memo on this topic before I — and hopefully many of my readers — head out for year-end holidays. I'll be 'writing not with regard to the right pace oil — about which I certainly have no unique insight — but rather, as indicated by the title, about what we can learn from recent experience.

Despite my protestations that I don't blow any more than about future macro events — and thus that my opinions on the macro are unlikely to help anyone achieve above average performance — people insist on asking about the future. Over the last eighteen months (since Ben Bernanke's initial mention that we were likely to see some "tapering" of bond buying), most of the macro questions I've gotten have about whether the Fed would move to increase interest rates, and particularly when. These are the questions that have been on everyone's mind.

Since mid-2013, the near-unanimous consensus (with credit to DoubleLine’s Jeffrey Gundlach for vocally departing from it) has been that rates would rise. And of course, the yield on the 10-year Treasury has fallen from roughly 3% at that time to 2.2% today. This year many investing institutions are underperforming the passive benchmarks and attributing part of the shortfall to the fact that their fixed income holdings have been too short in duration to allow them to benefit from the decline of interest rates. While this has nothing to do with oil, I mention it to provide a reminder that what "everyone knows" is usually unhelpful at best and wrong at worst.

Not only did the investing herd have the outlook for rates wrong, but it was uniformly inquiring about the wrong thing. In short, while everyone was asking whether the rate rise would begin in December 2014 or April 2015 (or might it be June?) — in response to which I consistently asked why the answer matters and how it might alter investment decisions — few people I know were talking about whether the price of oil was in for a significant change.

 Back in 2007, in It’s All Good, I provided a brief list of some possibilities for which I thought stock-prices weren't giving enough allowance. I included “$100 oil" (since a barrel was selling the $70s at the time) and ended with "the things I haven't thought of." I suggested that it's usually that last category — the things that haven't been considered — we should worry about most. Asset prices are often set to allow for the risks people are aware of. It's the ones they haven't thought of that can knock the market for a loop.

In my book The Most Important Thing, I mentioned something I call “the failure of imagination.” I defined it as “either being unable to conceive of the full range of possible outcomes or not understanding the consequences of the more extreme occurrences.” Both aspects of the definition apply here.

 The usual starting point for forecasting something is its current level. Most forecasts extrapolate, perhaps making modest adjustments up or down. In other words, most forecasting is done incrementally, and few predictors contemplate order-of-magnitude changes. Thus I imagine that with Brent crude around $110 six months ago, the bulls were probably predicting $115 or $120 and the bears $105 or $100. Forecasters usually stick too closely to the current level, and on t hose rare occasions when they call for change, they often underestimate the potential magnitude. Very few people predicted oil would decline significantly, and fewer still mentioned the possibility that we would see $60 within six months.

For several decades, Byron Wien of Blackstone (and formerly of Morgan Stanley, where he authored widely read strategy pieces) has organized summer lunches in the Hamptons for “serious,” prominent investors. At the conclusion of the 2014 series in August, he reported as follows with regard to the consensus of the participants:  

Most believed that the price of oil would remain around present levels. Several trillion dollars have been invested in drilling over the last few years and yet production is flat because Nigeria, Iraq and Libya are producing less. The U.S. and Europe are reducing consumption, but that is being more than offset by increasing demand from the developing world, particularly China. Five years from now the price of Brent is likely to be closer to $120 because of emerging market demand.

I don’t mean to pick on Byron or his luncheon guests. In fact, I think the sentiments he reported were highly representative of most investors’ thinking at the time.

As a side note, it’s interesting to observe that growth in China already was widely understood to be slowing, but perhaps that recognition never made its way into the views on oil of those present at Byron’s lunches. This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis

Turning to the second aspect of “the failure of imagination” and going beyond the inability of most people to imagine extreme outcomes, the current situation with oil also illustrates how difficult it is to understand the full range of potential ramifications. Most people easily grasp the immediate impact of developments, but few understand the “second-order” consequences . . . as well as the third and fourth. When these latter factors come to be reflected in asset prices, this is often referred to as “contagion.” Everyone knew in 2007 that the sub-prime crisis would affect mortgage-backed securities and homebuilders, but it took until 2008 for them to worry equally about banks and the rest of the economy.

The following list is designed to illustrate the wide range of possible implications of an oil price decline, both direct consequences and their ramifications:

• Lower prices mean reduced revenue for oil-producing nations such as Saudi Arabia, Russia and Brunei, causing GDP to contract and budget deficits to rise.
• There’s a drop in the amounts sent abroad to purchase oil by oil-importing nations like the U.S., China, Japan and the United Kingdom.
• Earnings decline at oil exploration and production companies but rise for airlines whose fuel costs decline.
• Investment in oil drilling declines, causing the earnings of oil services companies to shrink, along with employment in the industry.
• Consumers have more money to spend on things other than energy, benefitting consumer goods companies and retailers.
• Cheaper gasoline causes driving to increase, bringing gains for the lodging and restaurant industries.
• With the cost of driving lower, people buy bigger cars – perhaps sooner than they otherwise would have – benefitting the auto companies. They also keep buying gasoline- powered cars, slowing the trend toward alternatives, to the benefit of the oil industry.
• Likewise, increased travel stimulates airlines to order more planes – a plus for the aerospace companies – but at the same time the incentives decline to replace older planes with fuel-efficient ones. (This is a good example of the analytical challenge: is the net impact on airplane orders positive or negative?)
• By causing the demand for oil services to decline, reduced drilling leads the service companies to bid lower for business. This improves the economics of drilling and thus helps the oil companies.
•  Ultimately, if things get bad enough for oil companies and oil service companies, banks and other lenders can be affected by their holdings of bad loans.

Further, it’s hard for most people  to understand the self-correcting aspects of economic events

• A decline in the price of gasoline induces people to drive more, increasing the demand for oil.
• A decline in the price of oil negatively impacts the economics of drilling, reducing additions to supply.
• A decline in the price of oil causes producers to cut production and leave oil in the ground to be sold later at higher prices.

In all these ways, lower prices either increase the demand for oil or reduce the supply, causing the price of oil to rise (all else being equal). In other words, lower oil prices – in and of themselves – eventually make for higher oil prices. This illustrates the dynamic nature of economics.

Finally, in addition to the logical but often hard-to-anticipate second-order consequences or knock-on effects, negative developments often morph in illogical ways. Thus, in response to cascading oil prices, “I’m going to sell out of emerging markets that rely on oil exports” can turn into “I’m going to sell out of all emerging markets,” even oil importers that are aided by cheaper oil.

In part the emotional reaction to negative developments is the product of surprise and disillusionment. Part of this may stem from investors’ inability to understand the “fault lines” that run through their portfolios. Investors knew changes in oil prices would affect oil companies, oil services companies, airlines and autos. But they may not have anticipated the effects on currencies, emerging markets and below-investment grade credit broadly. Among other things, they rarely understand that capital withdrawals and the resulting need for liquidity can lead to urgent selling of assets that are completely unrelated to oil. People often fail to perceive that these fault lines exist, and that contagion can reach as far as it does. And then, when that happens, investors turn out to be unprepared, both intellectually and emotionally.  

A grain of truth underlies most big up and down moves in asset prices. Not just “oil’s in oversupply” today, but also “the Internet will change the world” and “mortgage debt has historically been safe.” Psychology and herd behavior make prices move too far in response to those underlying grains of truth, causing bubbles and crashes, but also leading to opportunities to make great sales of overpriced assets on the rise and bargain purchases in the subsequent fall. If you think markets are logical and investors are objective and unemotional, you’re in for a lot of surprises. In tough times, investors often fail to apply discipline and discernment; psychology takes over from fundamentals; and “all correlations go to one,” as things that should be distinguished from each other aren’t.

To give you an idea about how events in one part of the economy can have repercussions in other economic and market segments, I’ll quote from some of the analyses I’ve received this week from Oaktree investment professionals:

• Energy is a very significant part of the high yield bond market. In fact, it is the largest sector today (having taken over from media/telecom, which has traditionally been the largest). This is the case because the exploration industry is highly capital-intensive, and the high yield bond market has been the easiest place to raise capital. The knock-on effects of a precipitous fall in bond prices in the biggest sector in the high yield bond market are potentially substantial: outflows of capital, and mutual fund and ETF selling. It would be great for opportunistic buyers if the selling gets to sectors that are fundamentally in fine shape . . .  because a number of them are. And, in fact, low oil prices can even make them better.
• An imperfect analogy might be instructive: capital market conditions for energy-related assets today are not unlike what we saw in the telecom sector in 2002. As in telecom, you’ve had the confluence of really cheap financing, innovative technology, and prices for the product that were quite stable for a good while. [To this list of contributing factors, I would add the not-uncommon myth of perpetually escalating demand for a product.] These conditions resulted in the creation of an oversupply of capacity in oil, leading to a downdraft. It’s historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general “contagion.”
• Selling has been reasonably indiscriminate and panicky (much like telecom in 2002) as managers have realized (too late) how overexposed they are to the energy sector. Trading desks do not have sufficient capital to make markets, and thus price swings have been predictably volatile. The oil selloff has also caused deterioration in emerging market fundamentals and may force spreads to gap out there. This ultimately may create a feedback loop that results in contagion to high yield bonds generally.

Over the last year or so, while continuing to feel that U.S. economic growth will be slow and unsteady in the next year or two, I came to the conclusion that any surprises were most likely to be to the upside. And my best candidate for a favorable development has been the possibility that the U.S. would sharply increase its production of oil and gas. This would make the U.S. oil-independent, making it a net exporter of oil and giving it a cost advantage in energy – based on cheap production from fracking and shale – and thus a cost advantage in manufacturing. Now, the availability of cheap oil all around the world threatens those advantages. So much for macro forecasting!

There’s a great deal to be said about the price change itself. A well-known quote from economist Rudiger Dornbusch goes as follows: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.” I don’t know if many people were thinking about whether the price of oil would change, but the decline of 40%- plus must have happened much faster than anyone thought possible.

Everyone knows” (now!) that the demand for oil turned soft (due to sluggish economic growth, increased fuel efficiency and the emergence of alternatives) at the same time that the supply was increasing (as new sources came on stream). Equally, everyone knows that lower demand and higher supply imply lower prices. Yet it seems few people recognized the ability of these changes to alter the price of oil. A good part of this probably resulted from belief in the ability of OPEC (meaning largely the Saudis) to support prices by limiting production.

A price that’s kept aloft by the operation of a cartel is, by definition, higher than it would be based on supply and demand alone. Maybe the thing that matters is how far the cartelized price is from the free-market price; the bigger the gap, the shorter the period for which the cartel will be able to maintain control. Initially a cartel or a few of its members may be willing to bear pain to support the price by limiting production even while others produce full-out. But there may come a time when the pain becomes unacceptable and the price supporters quit. The key lesson here may be that cartels and other anti-market mechanisms can’t hold forever. As Herb Stein said, “If something cannot go on forever, it will stop.” Maybe we’ve just proved that this extends to the effectiveness of cartels.

Anyway, on the base of 93 million barrels a day of world oil use, some softness in consumption combined with an increase in production to cut the price by more than 40% in just a few months. What this proves – about most things – is that to Dornbusch’s quote above we should append the words “. . . and they go much further than you thought they could.”

The extent of the price decline seems much greater than the changes in supply and demand would call for. Perhaps to understand it you have to factor in (a) Saudi Arabia’s ceasing to balance supply and demand in the oil market by cutting production, after having done so for many years, and (b) a large contribution to the decline on the part of psychology. (In the “conspiracy theory” department, consider the rumor that Saudi Arabia is allowing or abetting the price drop in order to either punish Iran, Iraq and ISIL; put the U.S. shale oil industry out of business; or discipline the more profligate members of OPEC . . . take your pick.)

The price of oil thus may have gone from too high (supported by OPEC and by Saudi Arabia in particular) to too low (depressed by negative psychology). It seems to me with regard to the latter that the price fell too far for some market participants to maintain their equanimity. I often imagine participants’ internal dialogues. At $110, I picture them saying, “I’ll buy like mad if it ever gets to $100.” Because of the way investor psychology works, at $90 they may say, “If it falls to $70, I’ll give serious thought to buying.” But at $60 the tendency is to say, “It’s a falling knife and there’s no way to know where it’ll stop; I wouldn’t touch it at any price.”

 It feels much better to buy assets while they’re rising. But it’s usually smarter to buy after they’ve fallen for a while. Bottom line, as noted above: there’s little logic in investor psychology.

I said it about gold in All That Glitters (November 2010), and it’s equally relevant to oil: it’s hard to analytically put a price on an asset that doesn’t produce income. In principle, a non-perishable commodity won’t be priced below the variable production cost of the highest-cost producer whose output is needed to satisfy total demand. But in reality and in the short run, strange things can happen. It’s clear that today’s oil price is well below that standard.

It’s hard to say what the right price is for a commodity like oil . . . and thus when the price is too high or too low. Was it too high at $100-plus, an unsustainable blip? History says no: it was there for 43 consecutive months through this past August. And if it wasn’t too high then, isn’t it laughably low today? The answer is that you just can’t say. Ditto for whether the response of the price of oil to the changes in fundamentals has been appropriate, excessive or insufficient. And if you can’t be confident about what the right price is, then you can’t be definite about financial decisions regarding oil.

In the last few years, as I said in The Role of Confidence (August 2013), investor sentiment has been riding high. Or, as Doug Kass pointed out this past summer, there’s been “a bull market in complacency.” Regardless, it seems that a market that was unconcerned about things like oil and its impact on economies and assets now has lost its composure. Especially given the pervasive role of energy in economic life, uncertainty about oil introduces uncertainty into many aspects of investing.

“Value investing” – the form of investing Oaktree practices – is supposed to be about buying based on the present value of assets, rather than conjecture about profit growth in the far-off future. But you can’t assess present value without taking some position on what the future holds, even if it’s only assuming a continuation of present conditions or perhaps – for the sake of conservatism – a considerably lower level. Recent events cast doubt on the ability to safely take any position.

One of the things that’s central to risk-conscious value investing is ascertaining the presence of a generous cushion in terms of “margin of safety.” This margin comes from conviction that conditions will be stable, financial performance is predictable, and/or an entry price is low relative to the asset’s intrinsic value. But when something as central as oil is totally up for grabs, as investors seem to think is the case today, it’s hard to know whether you have an adequate margin. Referring to investing, Charlie Munger told me, “It’s not supposed to be easy.” The recent events surrounding oil certainly prove that it isn’t.

On the other hand – and in investing there’s always another hand – high levels of confidence, complacency and composure on the part of investors have in good measure given way to disarray and doubt, making many markets much more to our liking. For the last few years, interest rates on the safest securities – brought low by central banks – have been coercing investors to move out the risk curve. Sometimes they’ve made that journey without cognizance of the risks they were taking, and without thoroughly understanding the investments they undertook. Now they find themselves questioning many of their actions, and it feels like risk tolerance is being replaced by risk aversion. This paragraph describes a process through which investors are made to feel pain, but also one that makes markets much safer and potentially more bargain-laden.

In particular with regard to the distress cycle, confident and optimistic credit markets permit the unwise extension of credit to borrowers who are undeserving but allowed to become overlevered nevertheless.  Negative subsequent developments can render providers of capital less confident, making the capital market less accommodative. This cycle of easy issuance followed by defrocking has been behind the three debt crises that delivered the best buying opportunities in our 26 years in distressed debt. We think it also holds the key to the creation of superior opportunities in the future.

We’ve argued for a few years that credit standards were dropping as investors – chasing yield – became less disciplined and less discerning. But we knew great buying opportunities wouldn’t arrive until a negative “igniter” caused the tide to go out, exposing the debt’s weaknesses. The current oil crisis is an example of something with the potential to grow into that role. We’ll see how far it goes.

For the last 3½ years, Oaktree’s mantra has been “move forward, but with caution.” For the first time in that span, with the arrival of some disarray and heightened risk aversion, events tell us it’s appropriate to drop some of our caution and substitute a degree of aggressiveness.

December 18, 2014

Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein.  Further, Oaktree makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

16 Rules for Investors to live by 

Wall Street Journal - 08/12/2014

U.S. stocks are hitting all-time highs. And doesn’t it feel good?

It has been three years since the S&P 500 has declined 10% or more from a recent high. Including dividends, the index has more than doubled in the past five years. The Dow Jones Industrial Average has 34 record highs this year alone. Even the Nasdaq is less than 6% away from its dot-com bubble peak.

But high returns breed complacency and create a false impression of how easy investing can be.

That makes it a great time to review some fundamental—if overlooked—investing truths. Here are 16 important ones I’ve learned.

1. All past market crashes are viewed as opportunities, but all future market crashes are viewed as risks.

If you can recognize the silliness in this, you are on your way to becoming a better long-term investor.

2. Most bubbles begin with a rational idea that gets taken to an irrational extreme.

Dot-com companies did change the world, land is limited and precious metals can hedge against inflation. But none of these stories justified paying outlandish prices for stocks, houses or gold. Bubbles are so easy to fall for precisely because, at least in part, they are based on solid logic.

3. “I don’t know” are three of the most underused words in investing.

I don’t know what the market will do next month. I don’t know when interest rates will rise. I don’t know how low oil prices will go. Nobody does. Listening to people who say they do will cost you a lot of money. Alas, you can’t charge a consulting fee for humility.

4. Short-term thinking is at the root of most investing problems.

If you can focus on the next five years while the average investor is focused on the next five months, you have a powerful edge. Markets reward patience more than any other skill.

5. Investing is overwhelmingly a game of psychology.

Success has less to do with your math skills—or your relationships with in-the-know investors—and more to do with your ability to resist the emotional urge to buy high and sell low.

6. Things change quickly—and more drastically than many think.

Fourteen years ago, Enron was on Fortune magazine’s list of the world’s most-admired companies, Apple was a struggling niche company, Greece’s economy was booming, and the Congressional Budget Office predicted the federal government would be effectively debt-free by 2009. There is a tendency to extrapolate the recent past, but 10 years from now the business world will look absolutely nothing like it does today.

7. Three of the most important variables to consider are the valuations of stocks when you buy them, the length of time you can stay invested, and the fees you pay to brokers and money managers.

These three items alone will have a major impact on how you perform as an investor.

8. There are no points awarded for difficulty.

Nobody cares how much effort you put into researching a stock, how detailed your spreadsheet is or how complicated your options strategy is. For many people, a diversified buy-and-hold strategy is the most reasonable way to invest. Some find it boring, but the purpose of investing isn’t to reduce boredom; it is to increase wealth.

9. A couple of times per decade, investors forget that recessions happen a couple of times per decade.

When recessions come, stocks tend to plunge. This is an unfortunate, but perfectly normal, part of the process—like a Florida hurricane. You should get used to it. If you are unable to stomach declines, consider another investment.

10. Don’t check your brokerage account once a day and your blood pressure only once a year.

Constant updates make investing more emotional than it needs to be. Check your brokerage account as infrequently as necessary to prevent you from becoming emotional about market moves.

11. You should pay the most attention to the investor who talks about his or her mistakes.

Avoid those investors who don’t—their mistakes are likely to be worse.

12. Change your mind when the facts change.

Admit when you are wrong. Learn from your mistakes. Ignore those who refuse to do the same. This will save you untold investing misery.

13. Read past stock-market predictions, and you will take current predictions less seriously.

Markets are complicated, and human emotions are unpredictable. Unless you have illegal insider information, predicting what stocks will do in the short run is unimaginably difficult.

14. There is no such thing as a normal economy, or a normal stock market.

Investors have a tendency to want to “wait for things to get back to normal,” but markets and economies are almost constantly in some state of absurdity, booming or busting at rates that seem (and are) unsustainable.

15. It can be difficult to tell the difference between luck and skill in investing.

There are millions of investors around the world. Randomness guarantees that some will be wildly successful by pure chance. But you will rarely find an investor who attributes his success to luck. When you combine a market system that generates randomness with a belief that your actions reflect your intelligence, you get some misleading results.

16. You are only diversified if some of your investments are performing worse than others.

Losing money on even a portion of your portfolio is hard for some people to swallow, so they gravitate toward what is performing well at the moment, often at their own expense.

—Morgan Housel is a columnist at the Motley Fool.

Corrections & Amplifications

The Dow Jones Industrial Average has had 34 record highs this year. In an earlier version, this column incorrectly gave the figure as 32.

The LEssons of Oil

Memo to: Oaktree Clients 

From: Howard Marks

Re: The Lessons of Oil

In April I had good results with Dare to Be Great II, starting from the base established in an earlier memo (Dare to Be Great, September 2006) and adding new thoughts that had occurred to me in the intervening years. Also in 2006 I wrote Risk, my first memo devoted entirely to this key subject. My thinking continued to develop, causing me to dedicate three chapters to risk among the twenty in my book The Most Important Thing. This memo adds to what I’ve previously written on the topic. 

What Risk Really Means

In the 2006 memo and in the book, I argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it “machinable,” and there is no substitute for the purposes of the calculations.

However, while volatility is quantifiable and machinable – and can also be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.

Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.

Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known.

In Dare to Be Great II, I described the time I spent advising a sovereign wealth fund about how to organize for the next thirty years. My presentation was built significantly around my conviction that risk can’t be quantified a priori. Another of their advisors, a professor from a business school north of New York, insisted it can. This is something I prefer not to debate, especially with people who’re sure they have the answer but haven’t bet much money on it. 

One of the things the professor was sure could be quantified was the maximum a portfolio could fall under adverse circumstances. But how can this be so if we don’t know how adverse circumstances can be or how they will influence returns? We might say “the market probably won’t fall more than x% as long as things aren’t worse than y and z,” but how can an absolute limit be specified? I wonder if the professor had anticipated that the S&P 500 could fall 57% in the global crisis. 

While writing the original memo on risk in 2006, an important thought came to me for the first time. Forget about a priori; if you define risk as anything other than volatility, it can’t be measured even after the fact. If you buy something for $10 and sell it a year later for $20, was it risky or not? The novice would say the profit proves it was safe, while the academic would say it was clearly risky, since the only way to make 100% in a year is by taking a lot of risk. I’d say it might have been a brilliant, safe investment that was sure to double or a risky dart throw that got lucky. 

If you make an investment in 2012, you’ll know in 2014 whether you lost money (and how much), but you won’t know whether it was a risky investment – that is, what the probability of loss was at the time you made it. To continue the analogy, it may rain tomorrow, or it may not, but nothing that happens tomorrow will tell you what the probability of rain was as of today. And the risk of rain is a very good analogue (although I’m sure not perfect) for the risk of loss. 

The Unknowable Future

It seems most people in the prediction business think the future is knowable, and all they have to do is be among the ones who know it. Alternatively, they may understand (consciously or unconsciously) that it’s not knowable but believe they have to act as if it is in order to make a living as an economist or investment manager.

On the other hand, I’m solidly convinced the future isn’t knowable. I side with John Kenneth Galbraith who said, “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.” There are several reasons for this inability to predict:

• We’re well aware of many factors that can influence future events, such as governmental actions, individuals’ spending decisions and changes in commodity prices. But these things are hard to predict, and I doubt anyone is capable of taking all of them into account at once. (People have suggested a parallel between this categorization and that of Donald Rumsfeld, who might have called these things “known unknowns”: the things we know we don’t know.)

• The future can also be influenced by events that aren’t on anyone’s radar today, such as calamities – natural or man-made – that can have great impact. The 9/11 attacks and the Fukushima disaster are two examples of things no one knew to think about. (These would be “unknown unknowns”: the things we don’t know we don’t know.)

• There’s far too much randomness at work in the world for future events to be predictable. As 2014 began, forecasters were sure the U.S. economy was gaining steam, but they were confounded when record cold weather caused GDP to fall 2.9% in the first quarter.

• And importantly, the connections between contributing influences and future outcomes are far too imprecise and variable for the results to be dependable.

That last point deserves discussion. Physics is a science, and for that reason an electrical engineer can guarantee you that if you flip a switch over here, a light will go on over there . . . every time. But there’s good reason why economics is called “the dismal science,” and in fact it isn’t much of a science at all. In just the last few years we’ve had opportunity to see – contrary to nearly unanimous expectations – that interest rates near zero can fail to produce a strong rebound in GDP, and that a reduction of bond buying on the part of the Fed can fail to bring on higher interest rates. In economics and investments, because of the key role played by human behaviour, you just can’t say for sure that “if A, then B,” as you can in real science. The weakness of the connection between cause and effect makes outcomes uncertain. In other words, it introduces risk.

Given the near-infinite number of factors that influence the future, the great deal of randomness present, and the weakness of the linkages, it’s my solid belief that future events cannot be predicted with any consistency. In particular, predictions of important divergences from trends and norms can’t be made with anything approaching the accuracy required for them to be helpful. 

Coping with the Unknowable Future

Here’s the essential conundrum: investing requires us to decide how to position a portfolio for future developments, but the future isn’t knowable.

Taken to slightly greater detail:

• Investing requires the taking of positions that will be affected by future developments.

• The existence of negative possibilities surrounding those future developments presents risk.

• Intelligent investors pursue prospective returns that they think compensate them for bearing the risk of negative future developments.

But future developments are unpredictable.How can investors deal with the limitations on their ability to know the future? The answer lies in the fact that not being able to know the future doesn’t mean we can’t deal with it. It’s one thing to know what’s going to happen and something very different to have a feeling for the range of possible outcomes and the likelihood of each one happening. Saying we can’t do the former doesn’t mean we can’t do the latter. 

The information we’re able to estimate – the list of events that might happen and how likely each one is – can be used to construct a probability distribution. Key point number one in this memo is that the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.

Since the future isn’t fixed and future events can’t be predicted, risk cannot be quantified with any precision. I made the point in Risk, and I want to emphasize it here, that risk estimation has to be the province of experienced experts, and their work product will by necessity be subjective, imprecise, and more qualitative than quantitative (even if it’s expressed in numbers).

There’s little I believe in more than Albert Einstein’s observation: “Not everything that counts can be counted, and not everything that can be counted counts.” I’d rather have an order-of-magnitude approximation of risk from an expert than a precise figure from a highly educated statistician who knows less about the underlying investments. British philosopher and logician Carveth Read put it this way: “It is better to be vaguely right than exactly wrong.” 

By the way, in my personal life I tend to incorporate another of Einstein’s comments: “I never think of the future – it comes soon enough.” We can’t take that approach as investors, however. We have to think about the future. We just shouldn’t accord too much significance to our opinions.

We can’t know what will happen. We can know something about the possible outcomes (and how likely they are). People who have more insight into these things than others are likely to make superior investors. As I said in the last paragraph of The Most Important Thing: 

Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail. 

In other words, in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.

Thinking in Terms of Diverse Outcomes

It’s the indeterminate nature of future events that creates investment risk. It goes without saying that if we knew everything that was going to happen, there wouldn’t be any risk.

The return on a stock will be a function of the relationship between the price today and the cash flows (income and sale proceeds) it will produce in the future. The future cash flows, in turn, will be a function of the fundamental performance of the company and the way its stock is priced given that performance. We invest on the basis of expectations regarding these things. It’s tautological to say that if the company’s earnings and the valuation of those earnings meet our targets, the return will be as expected. The risk in the investment therefore comes from the possibility that one or both will come in lower than we think.

To oversimplify, investors in a given company may have an expectation that if A happens, that’ll make B happen, and if C and D also happen, then the result will be E. Factor A may be the pace at which a new product finds an audience. That will determine factor B, the growth of sales. If A is positive, B should be positive. Then if C (the cost of raw materials) is on target, earnings should grow as expected, and if D (investors’ valuation of the earnings) also meets expectations, the result should be a rising share price, giving us the return we seek (E).

We may have a sense for the probability distributions governing future developments, and thus a feeling for the likely outcome regarding each of developments A through E. The problem is that for each of these, there can be lots of outcomes other than the ones we consider most likely. The possibility of less- good outcomes is the source of risk. That leads me to my second key point, as expressed by Elroy Dimson, a professor at the London Business School: “Risk means more things can happen than will happen.” This brief, pithy sentence contains a great deal of wisdom. 

Here’s how I put it in No Different This Time – The Lessons of ’07 (December 2007): 

No ambiguity is evident when we view the past. Only the things that happened happened. But that definiteness doesn’t mean the process that creates outcomes is clear-cut and dependable. Many things could have happened in each case in the past, and the fact that only one did happen understates the variability that existed. What I mean to say (inspired by Nicolas Nassim Taleb’s Fooled by Randomness) is that the history that took place is only one version of what it could have been. If you accept this, then the relevance of history to the future is much more limited than may appear to be the case. 

People who rely heavily on forecasts seem to think there’s only one possibility, meaning risk can be eliminated if they just figure out which one it is. The rest of us know many possibilities exist today, and it’s not knowable which of them will occur. Further, things are subject to change, meaning there will be new possibilities tomorrow. This uncertainty as to which of the possibilities will occur is the source of risk in investing. 

Even a Probability Distribution isn't Enough

I’ve stressed the importance of viewing the future as a probability distribution rather than a single predetermined outcome. It’s still essential to bear in mind key point number three: Knowing the probabilities doesn’t mean you know what’s going to happen. For example, every good backgammon player knows the probabilities governing throws of the dice. They know there are 36 possible outcomes, and that six of them add up to the number seven (1-6, 2-5, 3-4, 4-3, 5-2 and 6-1). Thus the chance of throwing a seven on any toss is 6 in 36, or 16.7%. There’s absolutely no doubt about that. But even though we know the probability of each number, we’re far from knowing what number will come up on a given roll.

Backgammon players are usually quite happy to make a move that will enable them to win unless the opponent rolls twelve, since only one combination of the dice will produce it: 6-6. The probability of rolling twelve is thus only 1 in 36, or less than 3%. But twelve does come up from time to time, and the people it turns into losers end up complaining about having done the “right” thing but lost. As my friend Bruce Newberg says, “There’s a big difference between probability and outcome.” Unlikely things happen – and likely things fail to happen – all the time. Probabilities are likelihoods and very far from certainties.

It’s true with dice, and it’s true in investing . . . and not a bad start toward conveying the essence of risk. Think again about the quote above from Elroy Dimson: “Risk means more things can happen than will happen.” I find it particularly helpful to invert Dimson’s observation for key point number four: Even though many things can happen, only one will.

In Dare to Be Great II, I discussed the fact that economic decisions are usually best made on the basis of “expected value”: you multiply each potential outcome by its probability, sum the results, and select the path with the highest total. But while expected value weights all of the possible outcomes on the basis of their likelihood, there may be some individual outcomes that absolutely cannot be tolerated. Even though many things can happen, only one will . . . and if something unacceptable can happen on the path with the highest expected value, we may not be able to choose on that basis. We may have to shun that path in order to avoid the extreme negative outcome. I always say I have no interest in being a skydiver who’s successful 95% of the time.

Investment performance (like life in general) is a lot like choosing a lottery winner by pulling one ticket from a bowlful. The process through which the winning ticket is chosen can be influenced by physical processes, and also by randomness. But it never amounts to anything but one ticket picked from among many. Superior investors have a better sense for the tickets in the bowl, and thus for whether it’s worth buying a ticket in a lottery. Lesser investors have less of a sense for the probability distribution and for whether the likelihood of winning the prize compensates for the risk that the cost of the ticket will be lost. 

Risk and Return

Both in the 2006 memo on risk and in my book, I showed two graphics that together make clear the nature of investment risk. People have told me they’re the best thing in the book, and since readers of this memo might have not seen the old one or read the book, I’m going to repeat them here.

The first one below shows the relationship between risk and return as it is conventionally represented. The line slopes upward to the right, meaning the two are “positively correlated”: as risk increases, return increases. 

In both the old memo and the book, I went to great lengths to clarify what this is often – but erroneously – taken to mean. We hear it all the time: “Riskier investments produce higher returns” and “If you want to make more money, take more risk.”

Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Misplaced reliance on the benefits of risk bearing has led investors to some very unpleasant surprises.

However, there’s another, better way to describe this relationship: “Investments that seem riskier have to appear likely to deliver higher returns, or else people won’t make them.” This makes perfect sense. If the market is rational, the price of a seemingly risky asset will be set low enough that the reward for holding it seems adequate to compensate for the risk present. But note the word “appear.” We’re talking about investors’ opinions regarding future return, not facts. Risky investments are – by definition – far from certain to deliver on their promise of high returns. For that reason, I think the graphic below does a much better job of portraying reality: 

Here the underlying relationship between risk and return reflects the same positive general tendency as the first graphic, but the result of each investment is shown as a range of possibilities, not the single outcome suggested by the upward-sloping line. At each point along the horizontal risk axis, an investment’s prospective return is shown as a bell-shaped probability distribution turned on its side.

The conclusions are obvious from inspection. As you move to the right, increasing the risk:

• the expected return increases (as with the traditional graphic),

• the range of possible outcomes becomes wider, and

• the less-good outcomes become worse.

This is the essence of investment risk. Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money. These investments are undertaken because the expected return is higher. But things may happen other than that which is hoped for. Some of the possibilities are superior to the expected return, but others are decidedly unattractive.

The first graph’s upward-sloping line indicates the underlying directionality of the risk/return relationship. But there’s a lot more to consider than the fact that expected returns rise along with perceived risk, and in that regard the first graph is highly misleading. The second graph shows both the underlying trend and the increasing potential for actual returns to deviate from expectations. While the expected return rises along with risk, so does the probability of lower returns . . . and even of losses. This way of looking at things reflects Professor Dimson’s dictum that more than one thing can happen. That’s reality in an unpredictable world. 

The Many Forms of Risk

The possibility of permanent loss may be the main risk in investing, but it’s not the only risk. I can think of lots of other risks, many of which contribute to – or are components of – that main risk.

In the past, in addition to the risk of permanent loss, I’ve mentioned the risk of falling short. Some investors face return requirements in order to make necessary payouts, as in the case of pension funds, endowments and insurance companies. Others have more basic needs, like generating enough income to live on.

Some investors with needs – particularly those who live on their income, and especially in today’s low- return environment – face a serious conundrum. If they put their money into safe investments, their returns may be inadequate. But if they take on incremental risk in pursuit of a higher return, they face the possibility of a still-lower return, and perhaps of permanent diminution of their capital, rendering their subsequent income lower still. There’s no easy way to resolve this conundrum.

There are actually two possible causes of inadequate returns: (a) targeting a high return and being thwarted by negative events and (b) targeting a low return and achieving it. In other words, investors face not one but two major risks: the risk of losing money and the risk of missing opportunities. Either can be eliminated but not both. And leaning too far in order to avoid one can set you up to be victimized by the other.

Potential opportunity costs – the result of missing opportunities – usually aren’t taken as seriously as real potential losses. But they do deserve attention. Put another way, we have to consider the risk of not taking enough risk. 

These days, the fear of losing money seems to have receded (since the crisis is all of six years in the past), and the fear of missing opportunities is riding high, given the paltry returns available on safe, mundane investments. Thus a new risk has arisen: FOMO risk, or the risk that comes from excessive fear of missing out. It’s important to worry about missing opportunities, since people who don’t can invest too conservatively. But when that worry becomes excessive, FOMO can drive an investor to do things he shouldn’t do and often doesn’t understand, just because others are doing them: if he doesn’t jump on the bandwagon, he may be left behind to live with envy.

Over the last three years, Oaktree’s response to the paucity of return has been to develop a suite of five credit strategies that we hope will produce a 10% return, either net or gross (we can’t claim to be more precise than that). I call them collectively the “ten percent solution,” after a Sherlock Holmes story called The Seven-Per-Cent Solution (we aim to do better). Talking to clients about these strategies and helping them choose between them has required me to focus on their risks.

“Just a minute,” you might say, “the ten-year Treasury is paying just 21⁄2% and, as Jeremy Grantham says, the risk-free rate is also return-free. How, then, can you target returns in the vicinity of 10%?” The answer is that it can’t be done without taking risk of some kind – and there are several candidates. I’ll list below a few risks that we’re consciously bearing in order to generate the returns our clients desire:

• Today’s ultra-low interest rates imply low returns for anyone who invests in what are deemed safe fixed income instruments. So Oaktree’s pursuit of attractive returns centers on accepting and managing credit risk, or the risk that a borrower will be unable to pay interest and repay principal as scheduled. Treasury's are assumed to be free of credit risk, and most high grade corporates are thought to be nearly so. Thus those who intelligently accept incremental credit risk must do so with the expectation that the incremental return promised as compensation will prove sufficient. Voluntarily accepting credit risk has been at the core of what Oaktree has done since its beginning in 1995 (and in fact since the seed was planted in 1978, when I initiated Citibank’s high yield bond effort). But bearing credit risk will lead to attractive returns only if it’s done well. Our activities are based on two beliefs: (a) that because the investing establishment is averse to credit risk, the incremental returns we receive for bearing it will compensate generously for the risk entailed and (b) that credit risk is manageable – i.e., unlike the general future, credit risk can be gauged by experts (like us) and reduced through credit selection. It wouldn’t make sense to voluntarily bear incremental credit risk if either of these two beliefs were lacking.

• Another way to access attractive returns in today’s low-rate environment is to bear illiquidity risk in order to take advantage of investors’ normal dislike for illiquidity (superior returns often follow from investor aversion). Institutions that held a lot of illiquid assets suffered considerably in the crisis of 2008, when they couldn’t sell them; thus many developed a strong aversion to them and in some cases imposed limitations on their representation in portfolios. Additionally, today the flow of retail money is playing a big part in driving up asset prices and driving down returns. Since retail money has a harder time making its way to illiquid assets, this has made the returns on the latter appear more attractive. It’s noteworthy that there aren’t mutual funds or ETFs for many of the things we’re investing in.

• Some strategies introduce it voluntarily and some can’t get away from it: concentration risk. “Everyone knows” diversification is a good thing, since it reduces the impact on results of a negative development. But some people eschew the safety that comes with diversification in favour of concentrating their investments in assets or with managers they expect to outperform. And some investment strategies don’t permit full diversification because of the limitations of their subject markets. Thus problems – if and when they occur – will be bigger per se.

• Especially given today’s low interest rates, borrowing additional capital to enhance returns is another way to potentially increase returns. But doing so introduces leverage risk. Leverage adds to risk two ways. The first is magnification: people are attracted to leverage because it will magnify gains, but under unfavorable outcomes it will magnify losses instead. The second way in which leverage adds to risk stems from funding risk, one of the classic reasons for financial disaster. The stage is set when someone borrows short-term funds to make a long-term investment. If the funds have to be repaid at an awkward time – due to their maturity, a margin call, or some other reason – and the purchased assets can’t be sold in a timely fashion (or can only be sold at a depressed price), an investment that might otherwise have been successful can be cut short and end in sorrow. Little or nothing may remain of the sale proceeds once the leverage has been repaid, in which case the investor’s equity will be decimated. This is commonly called a meltdown. It’s the primary reason for the saying, “Never forget the six-foot- tall man who drowned crossing the stream that was five feet deep on average.” In times of crisis, success over the long run can become irrelevant.

• When credit risk, illiquidity risk, concentration risk and leverage risk are borne intelligently, it is in the hope that the investor’s skill will be sufficient to produce success. If so, the potential incremental returns that appear to be offered as risk compensation will turn into realized incremental returns (per the graphic at the top of page 6). That’s the only reason anyone would do these things. As the graphic at the bottom of page 6 illustrates, however, investing further out on the risk curve exposes one to a broader range of investment outcomes. In an efficient market, returns are tethered to the market average; in an inefficient market, they’re not. Inefficient markets offer the possibility that an investor will escape from the “gravitational pull” of the market’s average return, but that can be either for the better or for the worse. Superior investors – those with “alpha,” or the personal skill needed to achieve outsized returns for a given level of risk – have scope to perform well above the mean return, while inferior investors can come out far below. So hiring an investment manager introduces manager risk: the risk of picking the wrong one. It’s possible to pay management fees but get decisions that detract from results rather than add.

Some or all of the above risks are potentially entailed in our new credit strategies. Parsing them allows investors to choose among the strategies and accept the risks they’re more comfortable with. The process can be quite informative.

Our oldest “new strategy” is Enhanced Income, where we use leverage to magnify the return from a portfolio of senior loans. We think senior loans have the lowest credit risk of anything Oaktree deals with, since they’re senior-most among their issuer’s debt and historically have produced very few credit losses. Further, they’re among our most liquid assets, meaning we face relatively little illiquidity risk, and being active in a broad public market permits us to diversify, reducing concentration risk. Given the relatively high degree of safety stemming from these loans’ seniority, returns aren’t overly dependent on the presence of alpha, meaning Enhanced Income entails less manager risk than some other strategies. But to have a chance at the healthy return we’re pursuing in Enhanced Income requires us to take some risk, and what we’re left with is leverage risk. The 3-to-1 leverage in Enhanced Income Fund II will magnify the negative impact of any credit losses (of course we hope there won’t be many). However, we’re not worried about a meltdown, since the current environment allows us to avoid funding risk; we can (a) borrow for a term that exceeds the duration of the underlying investments and (b) do so without the threat of margin calls related to price declines.

Strategic Credit, Mezzanine Finance, European Private Debt and Real Estate Debt are the other four components of our “ten percent solution.”

• All four entail some degree of credit risk, illiquidity risk (they all invest heavily or entirely in private debt) and concentration risk (as their market niches offer only a modest number of investment opportunities, and securing them in today’s competitive environment is a challenge).

• The Real Estate Debt Fund can only lever up to 1-to-1, and the other three borrow only small amounts and for short-term purposes, so none of them entails significant leverage risk.

• However, in order to succeed they’ll all require a high level of skill from their managers in identifying return prospects and keeping risk under control. Thus they all entail manager risk. Our response is to entrust these portfolios only to managers who’ve been with us for years.

It’s reasonable – essential, really – to study the risk entailed in every investment and accept the amounts and types of risk that you’re comfortable with (assuming this can be discerned). It’s not reasonable to expect highly superior returns without bearing some incremental risk.

I touched above on concentration risk, but we should also think about the flip side: the risk of over- diversification. If you have just a few holdings in a portfolio, or if an institution employs just a few managers, one bad decision can do significant damage to results. But if you have a very large number of holdings or managers, no one of them can have much of a positive impact on performance. Nobody invests in just the one stock or manager they expect to perform best, but as the number of positions is expanded, the standards for inclusion may decline. Peter Lynch coined the term “diworstification” to describe the process through which lesser investments are added to portfolios, making the potential risk- adjusted return worse.

While I don’t think volatility and risk are synonymous, there’s no doubt that volatility does present risk. If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors’ emotions, reducing the probability they’ll do the right thing. And in the short run, it can be very hard to differentiate between a downward fluctuation and a permanent loss. Often this can really be done only in retrospect. Thus it’s clear that a professional investor may have to bear consequences for a temporary downward fluctuation simply because of its resemblance to a permanent loss. When you’re under pressure, the distinction between “volatility” and “loss” can seem only semantic. Volatility is not “the” definition of investment risk, as I said earlier, but it isn’t irrelevant.

One example of a risk connected with volatility – or the deviation of price from what might be intrinsic value – is basis risk. Arbitrageurs customarily set up positions where they’re long one asset and short a related asset. The two assets are expected to move roughly in parallel, except that the one that’s slightly cheaper should make more money for the investor in the long run than the other loses, producing a small net gain with little risk. Because these trades are considered so low in risk, they’re often levered up to the sky. But sometimes the prices of the two assets diverge to an unexpected extent, and the equity invested in the trade evaporates. That unexpected divergence is basis risk, and it’s what happened to Long-Term Capital Management in 1998, one of the most famous meltdowns of all time. As Long-Term’s chairman John Meriwether said at the time, “the Fund added to its positions in anticipation of convergence, yet . . . the trades diverged dramatically.” This benign-sounding explanation was behind a collapse some thought capable of bringing down the global financial system. 

Long-Term’s failure was also attributable to model risk. Decisions can be turned over to quants or financial engineers who either (a) conclude wrongly that an unsystematic process can be modeled or (b) employ the wrong model. During the financial crisis, models often assumed that events would occur according to a “normal distribution,” but extreme “tail events” occurred much more often than the normal distribution says they will. Not only can extreme events exceed a model’s assumptions, but excessive belief in a model’s efficacy can induce people to take risks they would never take on the basis of qualitative judgement. They’re often disappointed to find they had put too much faith in a statistical sure thing.

Model risk can arise from black swan risk, for which I borrow the title of Nassim Nicholas Taleb’s popular second book. People tend to confuse “never been seen” with “impossible,” and the consequences can be dire when something occurs for the first time. That’s part of the reason why people lost so much in highly levered subprime mortgage securities. The fact that a nationwide spate of mortgage defaults hadn’t happened convinced investors that it couldn’t happen, and their certainty caused them to take actions so imprudent that it had to happen.

As long as we’re on the subject of things going wrong, we should touch on the subject of career risk. As I mentioned in Dare to Be Great II, “agents” who manage money for others can be penalized for investments that look like losers (that is, for both permanent losses and temporary downward fluctuations). Either of these unfortunate experiences can result in headline risk if the resulting losses are big enough to make it into the media, and some careers can’t withstand headline risk. Investors who lack the potential to share commensurately in investment successes face a reward asymmetry that can force them toward the safe end of the risk/return curve. They are likely to think more about the risk of losing money than about the risk of missing opportunities. Thus their portfolios may lean too far toward controlling risk and avoiding embarrassment (and they may not take enough chances to generate returns). There are consequences for these investors, as well as for those who employ them.

Event risk is another risk to worry about, something that was created by bond issuers about twenty years ago. Since corporate directors have a fiduciary responsibility to stockholders but not to bondholders, some think they can (and perhaps should) do anything that’s not explicitly prohibited to transfer value from bondholders to stockholders. Bondholders need covenants to shield them from this kind of pro- active plundering, but at times like today it can be hard to obtain strong protective covenants.

There are many ways for an investment to be unsuccessful. The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake.

On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about. Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble.

Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story. Correlation is the essential additional piece of the puzzle. Correlation is the degree to which an asset’s price will move in sympathy with the movements of others. The higher the correlation among its components, all other things being equal, the less effective diversification a portfolio has, and the more exposed it is to untoward developments.

An asset doesn’t have “a correlation.” Rather, it has a different correlation with every other asset. A bond has a certain correlation with a stock. One stock has a certain correlation with another stock (and a different correlation with a third). Stocks of one type (such as emerging market, high-tech or large-cap) are likely to be highly correlated with others within their category, but they may be either high or low in correlation with those in other categories. Bottom line: it’s hard to estimate the riskiness of a given asset, but many times harder to estimate its correlation with all the other assets in a portfolio, and thus the impact on performance of adding it to the portfolio. This is a real art.

Fixed income investors are directly exposed to another form of risk: interest rate risk. Higher interest rates mean lower bond prices – that relationship is absolute. The impact of changes in interest rates on asset classes other than fixed income is less direct and less obvious, but it also pervades the markets. Note that stocks usually go down when the Fed says the economy is performing strongly. Why? The thinking is that stronger economy = higher interest rates = more competition for stocks from bonds = lower stock valuations. Or it might be stronger economy = higher interest rates = reduced stimulus = weaker economy.

One of the reasons for increases in interest rates relates to purchasing power risk. Investors in securities (and especially long-term bonds) are exposed to the risk that if inflation rises, the amount they receive in the future will buy less than it could today. This causes investors to insist on higher interest rates and higher prospective returns to protect them against the loss of purchasing power. The result is lower prices.

Finally, I want to mention a new concept I hear about once in a while: upside risk. Forecasters are sometimes heard to say “the risk is on the upside.” At first this doesn’t seem to have much legitimacy, but it can be about the possibility that the economy may catch fire and do better than expected, earnings may come in above consensus, or the stock market may appreciate more than people think. Since these things are positives, there’s risk in being underexposed to them.

*              *              *

To move to the biggest of big pictures, I want to make a few over-arching comments about risk.

The first is that risk is counterintuitive.

• The riskiest thing in the world is the widespread belief that there’s no risk.

• Fear that the market is risky (and the prudent investor behavior that results) can render it quite safe.

• As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal).

• As an asset appreciates, causing people to think more highly of it, it becomes riskier.

• Holding only “safe” assets of one type can render a portfolio under-diversified and make it vulnerable to a single shock.

• Adding a few “risky” assets to a portfolio of safe assets can make it safer by increasing its diversification. Pointing this out was one of Professor William Sharpe’s great contributions. 

The second is that risk aversion is the thing that keeps markets safe and sane.

• When investors are risk-conscious, they will demand generous risk premiums to compensate them for bearing risk. Thus the risk/return line will have a steep slope (the unit increase in prospective return per unit increase in perceived risk will be large) and the market should reward risk-bearing as theory asserts.

• But when people forget to be risk-conscious and fail to require compensation for bearing risk, they’ll make risky investments even if risk premiums are skimpy. The slope of the line will be gradual, and risk taking is likely to eventually be penalized, not rewarded.

• When risk aversion is running high, investors will perform extensive due diligence, make conservative assumptions, apply skepticism and deny capital to risky schemes.

• But when risk tolerance is widespread instead, these things will fall by the wayside and deals will be done that set the scene for subsequent losses.

Simply put, risk is low when risk aversion and risk consciousness are high, and high when they’re low.

The third is that risk is often hidden and thus deceptive. Loss occurs when risk – the possibility of loss – collides with negative events. Thus the riskiness of an investment becomes apparent only when it is tested in a negative environment. It can be risky but not show losses as long as the environment remains salutary. The fact that an investment is susceptible to a serious negative development that will occur only infrequently – what I call “the improbable disaster” – can make it appear safer than it really is. Thus after several years of a benign environment, a risky investment can easily pass for safe. That’s why Warren Buffett famously said, “. . . you only find out who’s swimming naked when the tide goes out.”

Assembling a portfolio that incorporates risk control as well as the potential for gains is a great accomplishment. But it’s a hidden accomplishment most of the time, since risk only turns into loss occasionally . . . when the tide goes out.

The fourth is that risk is multi-faceted and hard to deal with. In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:

• Efforts to reduce the risk of losing money invariably increase the risk of missing out.

• Efforts to reduce fundamental risk by buying higher-quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics.

At bottom, it’s the inability to arrive at a single formula that simultaneously minimizes all the risks that makes investing the fascinating and challenging pursuit it is.

The fifth is that the task of managing risk shouldn’t be left to designated risk managers. I’m convinced outsiders to the fundamental investment process can’t know enough about the subject assets to make appropriate decisions regarding each one. All they can do is apply statistical models and norms. But those models may be the wrong ones for the underlying assets – or just plain faulty – and there’s little evidence that they add value. In particular, risk managers can try to estimate correlation and tell you how things will behave when combined in a portfolio. But they can fail to adequately anticipate the “fault lines” that run through portfolios. And anyway, as the old saying goes, “in times of crisis all correlations go to one” and everything collapses in unison.

“Value at Risk” was supposed to tell the banks how much they could lose on a very bad day. During the crisis, however, VaR was often shown to have understated the risk, since the assumptions hadn’t been harsh enough. Given the fact that risk managers are required at banks and de rigueur elsewhere, I think more money was spent on risk management in the early 2000s than in the rest of history combined . . . and yet we experienced the worst financial crisis in 80 years. Investors can calculate risk metrics like VaR and Sharpe ratios (we use them at Oaktree; they’re the best tools we have), but they shouldn’t put too much faith in them. The bottom line for me is that risk management should be the responsibility of every participant in the investment process, applying experience, judgment and knowledge of the underlying investments.

The sixth is that while risk should be dealt with constantly, investors are often tempted to do so only sporadically. Since risk only turns into loss when bad things happen, this can cause investors to apply risk control only when the future seems ominous. At other times they may opt to pile on risk in the expectation that good things lie ahead. But since we can’t predict the future, we never really know when risk control will be needed. Risk control is unnecessary in times when losses don’t occur, but that doesn’t mean it’s wrong to have it. The best analogy is to fire insurance: do you consider it a mistake to have paid the premium in a year in which your house didn’t burn down?

Taken together these six observations convince me that Charlie Munger’s trenchant comment on investing in general – “It’s not supposed to be easy. Anyone who finds it easy is stupid.” – is profoundly applicable to risk management. Effective risk management requires deep insight and a deft touch. It has to be based on a superior understanding of the probability distributions that will govern future events. Those who would achieve it have to have a good sense for what the crucial moving parts are, what will influence them, what outcomes are possible, and how likely each one is. Following on with Charlie’s idea, thinking risk control is easy is perhaps the greatest trap in investing, since excessive confidence that they have risk under control can make investors do very risky things.

Thus the key prerequisites for risk control also include humility, lack of hubris, and knowing what you don’t know. No one ever got into trouble for confessing a lack of prescience, being highly risk- conscious, and even investing scared. Risk control may restrain results during a rebound from crisis conditions or extreme under-valuations, when those who take the most risk generally make the most money. But it will also extend an investment career and increase the likelihood of long-term success. That’s why Oaktree was built on the belief that risk control is “the most important thing.”

Lastly while dealing in generalities, I want to point out that whereas risk control is indispensable, risk avoidance isn’t an appropriate goal. The reason is simple: risk avoidance usually goes hand- in-hand with return avoidance. While you shouldn’t expect to make money just for bearing risk, you also shouldn’t expect to make money without bearing risk. 

*              *              *

At present I consider risk control more important than usual. To put it briefly:

• Today’s ultra-low interest rates have brought the prospective returns on money market instruments, Treasurys and high grade bonds to nearly zero.

• This has caused money to flood into riskier assets in search of higher returns.

• This, in turn, has caused some investors to drop their usual caution and engage in aggressive tactics.

• And this, finally, has caused standards in the capital markets to deteriorate, making it easy for issuers to place risky securities and – consequently – hard for investors to buy safe ones.

Warren Buffett put it best, and I regularly return to his statement on the subject:

. . . the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

While investor behaviour hasn’t sunk to the depths seen just before the crisis (and, in my opinion, that contributed greatly to it), in many ways it has entered the zone of imprudence. To borrow a metaphor from Chuck Prince, Citigroup’s CEO from 2003 to 2007, anyone who’s totally unwilling to dance to today’s fast-paced music can find it challenging to put money to work.

It’s the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity. Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last three years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.”

Economic and company fundamentals in the U.S. are fine today, and asset prices – while full – don’t seem to be at bubble levels. But when undemanding capital markets and a low level of risk aversion combine to encourage investors to engage in risky practices, something usually goes wrong eventually. Although I have no idea what could make the day of reckoning come sooner rather than later, I don’t think it’s too early to take today’s carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium. We have to behave accordingly.

September 3, 2014 

Legal Information and Disclosures.

 This memorandum, including the information contained herein, may not be copied, reproduced, republished, posted, transmitted, distributed, disseminated or disclosed, in whole or in part, to any other person in any way without the prior written consent of Oaktree Capital Management, L.P. (together with its affiliates, “Oaktree”). This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Any reference to return goals is purely hypothetical and is not, and should not be considered, a guarantee nor a prediction or projection of future results. Actual returns often differ, in many cases materially, from any return goal as a result of many factors, including but not limited to the availability of suitable investments, the uncertainty of future operating results of investments, the timing of asset acquisitions and disposals, and the general economic conditions that prevail during the period that an investment is acquired, held or disposed of. You should bear in mind that returns goals are not indicative of future results, and there can be no assurance that the credit strategies will achieve comparable results, that return goals will be met or that the credit strategies will be able to implement its investment strategy or achieve its investment objectives. Moreover, wherever there is the potential for profit there is also the possibility of loss. This memorandum is being made available for educational purposes only and does not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities, or an offer invitation or solicitation of any specific funds or the fund management services of Oaktree, or an offer or invitation to enter into any portfolio management mandate with Oaktree in any jurisdiction. Any offer of securities or funds may only be made pursuant to a confidential private placement memorandum, subscription documents and constituent documents in their final form. An investment in any fund or the establishment of an account within Oaktree’s credit strategies is speculative and involves a high degree of risk. There can be no assurance that investments targeted by each of the strategies will increase in value, that significant losses will not be incurred or that the objectives of the strategies will be achieved. Moreover, a portfolio within one of the credit strategies may not be diversified among a wide range of issuers, industries and countries, making the portfolio subject to more rapid changes in value than would be the case if the portfolio was more diversified.
Many factors affect the demand and supply of securities and instruments targeted by the strategies discussed herein and their valuation. Interest rates and general economic activity may affect the value and number of investments made by such strategies. Such strategies discussed herein may target investments in companies whose capital structures may have significant leverage. Such investments are inherently more sensitive than others to declines in revenues and to increases in expenses and interest rates. In addition, such strategies may involve the use of leverage. While leverage presents opportunities for increasing total return, it may increase losses as well. Accordingly, any event that adversely affects the value of an investment would be magnified to the extent leverage is used. Such strategies may also involve securities or obligations of non-U.S. companies which may involve certain special risks. These factors may increase the likelihood of potential losses being incurred in connection with such investments. The investments that are part of such strategies could require substantial workout negotiations or restructuring in the event of a bankruptcy, which could entail significant risks, time commitments and costs. The investments targeted by such strategies may be thinly traded, may be subject to restrictions on resale or may be private securities. In such cases, the primary resale opportunities for such investments are privately negotiated transactions with a limited number of purchasers. This may restrict the disposition of investments in a timely fashion and at a favorable
price. In addition, real estate-related investments can be seriously affected by interest rate fluctuations, bank liquidity, the availability of financing, and by regulatory or governmentally imposed factors such asa zoning change, an increase in property taxes, the imposition of height or density limitations, the requirement that buildings be accessible to disabled persons, the requirement for environmental impact studies, the potential costs of remediation of environmental contamination or damage, the imposition of special fines to reduce traffic congestion or to provide for housing, competition from other investors, changes in laws, wars, and earthquakes, typhoons, terrorist attacks or other similar events. Income from income-producing real estate may be adversely affected by general economic conditions, local conditions such as oversupply or reduction in demand for space in the area, competition from other available properties, and the owner provision of adequate maintenance and coverage by adequate insurance. Oaktree may be required for business or other reasons to foreclose on one or more mortgages held in such strategy’s portfolio. Foreclosures can be lengthy and expensive and borrowers often assert claims, counterclaims and defenses to delay or prevent foreclosure actions. Responses to any inquiry that may involve the rendering of personalized investment advice or effecting or attempting to effect transactions in securities will not be made absent compliance with applicable laws or regulations (including broker dealer, investment adviser, or applicable agent or representative registration requirements), or applicable exemptions or exclusions therefrom. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Oaktree believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.